Best of Five Years (6): stock markets in developing countries (lV): what we can do to add value

I’ve been writing Practical Stock Investing for something over five years now. I decided to go back through my archives so look at the most looked-at (and possibly read) posts over that time. I’m going to re-post ten over the next two weeks. This will give you a chance to see some of my earlier work that you may have missed. And I’ll have time for home repairs I’ve been putting off. I may just see a couple of baseball games and watch the basketball playoffs, though.

Here’s #6.

The easiest and safest way to invest in emerging markets is to buy a broad index fund or ETF that covers these markets. But if you are willing to do some work, there are four things I think you can do to to focus your money on potentially higher return areas. All contain some risk and require that you not simply buy and forget but continue to monitor your investment regularly. You may also find yourself limited by your broker’s ability to transact in certain areas (can you buy? …and, more important, if you change your mind, can you get out)?.

The four are:

1. focus on healthy countries. Stable, foreigner-friendly, government is the first requirement (leaving out places like Venezuela). Ideally, the government budget should be balanced, or close to it. The stock of government debt, as a percentage of GDP, should not be rising rapidly. The country should generate enough foreign exchange through exports to comfortably cover its foreign debt service. Imports should be mostly machinery or other items to help build up the country’s industrial base–not consumer items like TVs. (By the way, on these criteria, except for stable government, the US and the UK would flunk the emerging markets investment test.)

2. use the export-oriented manufacturing development model. Successful developing countries have, by and large, grown by encouraging technology transfer in support of export-oriented manufacturing. This means the country invites foreign firms to set up manufacturing bases within the country, so the local workforce can develop their skills. To do this, the country must offer electric power, communication, fresh water, a road network and ports. In developing countries, these are all growth industries.

3. reach in to the developing country indirectly, through a company in a developed market that has, say, a third of its operations in the developing world. Many western European companies, especially in consumer staples, have subsidiaries in Eastern Europe, for example. Most former colonial powers have trading companies or telecom firms that still operate in their former colonies. In addition to the mainland firms listed in Hong Kong, that market also has many property and trading firms with large China exposure.

The advantage to doing this is that you get Western management, whose motivations you can easily understand, plus developing market growth potential. One thing to watch for, though–old colonial masters may not be A-listers in a former colony. The old Hong Kong opium firms still controlled by non-Chinese are an example.

4. find an active manager who has a consistent record of beating the index in a given area. The Matthews China Fund comes to mind as an example. Either on a discount broker website, Morningstar, or the fund group’s website, you can see the historical record. Make sure the same people who achieved the record are still around, though.